A Healthy and Vibrant Economy Finance Essay

A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities Mishkin, 2009. Therefore, the first and most important aim of each economy in any country is to preserve a long term economic growth and to maintain efficiency in the lending-borrowing process. For example, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their securities in the market (Mishkin, 2009), this way, the securities market will then be able to transfer funds to the good firms that have the most productive investment opportunities. The question arisen is the following: Does the job of stock markets and financial institutions sponsor economic growth? One line of research says it does: i.e. stock market does lead to economic growth and financial institutions enhance economic growth. Such result is obvious in Beck and Levine (2004). However, according to Krueger (2006), the financial sector is not the key to development and growth. It is thus vital to take a look into the history of such impact in developing countries such as the MENA region and specifically Lebanon, and to mention the role of financial information in financial markets, and to what extent it can affect any purchase or sale of a marketable security.

The positive relation between stock markets, financial institutions and economic growth

Let's firstly define the role of financial institutions in financial markets and how did it evolve throughout the years. Commercial activities in a Barter Economy were limited between two nations or business communities as per the Economy Watch (2010). However, this economy presented many drawbacks when it comes to trade; the concepts of "money" and "barter" don't match together, moreover, there has to be double coincidence of wants for exchange to take place and the problem of indivisibility of commodities comes in the matter of exchange. This led to the rise of an intermediary, specifically the financial markets, which will facilitate the flow of funds from individual surplus units to deficit units and where financial institutions participate and operate in a manner to maximize shareholders' wealth. In addition, if financial markets were perfect, all information about any securities for sale in primary and secondary markets would be continuously and freely available to investors. So, all securities for sale could be unbundled into any size desired by investors, and security transaction costs would be nonexistent (Madura, 2003). This implies that there is no necessity for financial intermediaries' existence. But because markets are imperfect, participants do not have full accessibility to information and cannot always break down securities to the precise size they desire. Thus, financial institutions are importantly needed to solve the troubles caused by market imperfections. For instance, financial institutions will use the information received of the requests on what securities are to be purchased or sold to match up buyers with sellers. In the 1960s and 1970s, deposits provided by surplus units to commercial banks and saving institutions were heavily regulated (Madura, 2003), but in the 1980s, saving institutions, insurance companies and other financial institutions were permitted more flexibility by regulators on the uses of funds (Krugman & Obstfeld, 2009). As regulations have been reduced, financial institutions had the opportunities to capitalize on economies of scale; i.e. commercial banks acquired other ones to produce a higher volume level of services rendered. By increasing the echelon of business supported, the average cost of services is reduced. Furthermore, the reduction in regulations has also allowed different types of financial institutions to capitalize on economies of scope, known as the industry consolidation (Brealey, Myers & Allen, 2011). Commercial banks have merged with saving institutions, securities firms, finance companies mutual funds and insurance companies which enabled the customer to benefit and to obtain information of all the financial services from a single financial institution at a lower cost. Let's take for instance an example of a new graduate who needs $60,000 for his new vending machines project to be implemented in an area where the demand for such products is high. For that reason, you know that it is an unmissed opportunity and would like to lend him the money so that he purchases the machines and to trigger the route of this project. However, to guard your investment, the legal part is seek to clarify all the crucial points specifying what will be the principal along with the interest to be repaid. Hiring the lawyer will cost an additional $500 so you realize that the total inflow from this transaction is not that worth business to invest in and decide not to go in it. This is why financial intermediaries are there to help the customer achieve the intended transaction from a single place at a lower cost which increases efficiency in trade, i.e. economic growth. On the other part, financial intermediaries focused on how investors can construct the best possible portfolio by diversifying and hence "not putting all the eggs in one basket" as the old adage states. During the late 1990s, many people scoffed at being diversified, because the idea of mixing the investments among stocks, bonds and other financial securities meant missing out on the soaring gains of tech stocks (Luccheth & Francis, 2002). But with the collapse of the tech bubble and then the fall of Enron Corp, the example that will be discussed in the next part, the danger of holding a portfolio in a single industry turned on the red alarm and induced a corrective action especially that many investors were hit home as a result of the mentioned threat. Additionally, financial intermediaries promoted of appraising the risk and return characteristics of an investment in terms of how that security held affects the risk and return of the portfolio instead of evaluating it in isolation. To illustrate, we consider the following question: Would we expect to find higher correlations (measure of the degree of relationship between two variables) between the returns on two companies in the same industry or in different industries (Besley & Brigham, 2005)? For example, would the correlation of returns on Ford's and General Motors' (GM) stocks be higher, or would the correlation coefficient be higher between Ford or GM and Procter & Gamble (P&G)? How would these correlations affect the risks of portfolios containing them? The answer would be that the choice shall go for the perfectly negatively correlated stocks so to reduce risk. Ford's and GM's returns should have a positive correlation of 0.9 since both are affected by auto sales. However, the correlation of Ford's and GM's returns with P&G's returns should be at about 0.3. What would the financial intermediary advice is to hold a two-stock portfolio consisting of Ford or GM plus P&G since it is less risky to hold a diversified portfolio than to carry stocks of the same industry. We elaborate our study to ask the following: Do financial institutions lead to a better economic growth or economic growth leads to better financial institutions? To summarize what was previously demonstrated, the rewards of sound financial markets are well known. These markets play a vital role in assembling savings and in allocating them to fruitful investment. Moreover, strong local markets can also provide a more stable source of financing for the public and the private sectors, protecting them to some extent against unstable investments. In several industrial countries, such as the United States and the United Kingdom, financial markets over the past decade have substantially improved economic performance, through the development a wide array of products that allow for a more efficient allocation of savings. This rapid financial development has helped boost growth in both countries (de Rato, 2007). For example, since the mid-1990s, productivity has grown by about 1 percent a year more in the United States than in the euro area. And almost half of this difference is accounted for by differences in productivity in the financial sector. Similarly, several countries in Latin America have made good progress in developing their financial markets. Pension and mutual funds in Chile have helped extend maturities and intensify financial markets. Similarly, both Brazil and Chile have developed foreign exchange derivatives markets which are among the most sophisticated in the world. These developments are helping to enhance stability and economic growth. Moreover, it is no coincidence that the economic growth leads to better financial institutions. The causality runs both ways. As macroeconomic policies have become more credible, and people are confident that inflation will remain low, demand for financial services will as a result increase. Thus, as the inflow to financial markets amplifies, the accessibility of credit increases, encouraging faster growth. And as financial markets become more sophisticated, and risk management and hedging become easier and clearer, economies become better able to manage volatility. In this framework, we conclude that countries carrying more developed financial sectors, stronger institutions, sound macroeconomic policies, and more open trade systems (de Rato, 2007) are more likely to entail an economic growth. Raising funds can be achieved either through debt markets or equity or stock markets. Stocks are claims to share in the net income (income after expenses and taxes) and the assets of any organization (Bodie, Kane & Marcus, 2008). If supposedly you own one share of common stock in a company that has issued one million shares, you are entitled to 1/million of the firm's net income and 1/million of the firm's assets. A recent report prepared by Pascale Balze, a case writer, Stephen Mezias, professor in INSEAD Business School Abu Dhabi, and Yousef BAZIAN, Partner, Corporate FinanceA atA PricewaterhouseCoopers (which firms provide industry-focused assurance, tax and advisory services to enhance value for clients) in September 2011 discusses the future of the MENA region within the next 5 years. This paper states that Most Private Equity (PE) firms that participated in the PwC/INSEAD survey continue to believe that the MENA region's sound demographics and vast natural resources will spur economic growth in the next five years. This activist outlook is largely driven by the growth predictions of the Gulf countries, the economic engine of the wider region, which has remained largely protected from the political chaos. PE firms are optimistic about the forecast of sectors such as healthcare, education, consumer goods, oil and gas, which are likely to benefit from government spending plans. PE firms are seeking to invest in industries such as railways, toll-ways, ports and utilities, which definitely attract billions in capital spending. As per the geography, PE firms will look growing outside the region in places like Turkey or as far as India and Sub-Saharan Africa or explore riskier markets such as Iraq. Within the region, PE firms say they are likely to invest more in Egypt, Saudi Arabia and United Arab Emirates. However, as PE firms regained confidence in the economic situation towards the end of 2010, the beginning of 2011 brought renewed worries as a result of the political and social protests that spread across the region. It started with Tunisia followed by Egypt. Instability was developed elsewhere in the region including Algeria, Bahrain, Jordan, Morocco and Oman, while the situation further deteriorated in Lybia, Syria and Yemen. Confronting this political uncertainty, many participants in the regional PE industry arrested their immediate investment plans in countries affected by the protests and exercised more caution before proceeding with investments elsewhere in the region. Yet, the industry remained confident for the remainder of 2011. This sentiment is driven by the fact that the GCC (Gulf Cooperation Council), which is the economic engine of the region, has been largely sheltered from the Middle East protests and prospects for its economic growth remain strong. From the investor's point of view, opportunities for PE investments arise in the outcome to develop skills of a rapidly growing population in the MENA region. Moreover, the efforts of oil exporting countries to diversify their economies by developing knowledge-based activities will generate further opportunities in the education sector, such as investments in private schools, adult education and preparation centers which will offer attractive returns. In addition, the healthcare sector in the MENA region attracted just 1% of investments (in value) in 2006 but has since increased to 43% in 2010. Large government spending in healthcare, growing population, superior desire for healthcare services, increased longevity, and the need to engage in the effects of unhealthy lifestyle problems are key factors driving PE investment in the health sector which again will contribute to economic growth. To recap, it is clear to state that sound financial institutions and stock markets are supposed to pool the inflows and to dedicate it in the right investments that will assure economic growth. Furthermore, as the economy becomes more stable with developmental projects taking place, demand for investments will increase and thus the load of work in the financial institutions will be boosted, leading to better financial institutions and stock markets. However, as the economy grows, and grows more complex situations; the financial sector needs to stay in a state of race. Banks shall grow and become more sophisticated in their ability to appraising scenarios for risks and returns. Constant and rapid growth needs to be withstood by a strong financial system, capable of allocating the needs of all the economy's chain. Those economies that have experienced rapid growth over the long term have faced vast structural change, as they have shifted from being primarily rural and agricultural to a more urban, manufacturing and service based economy. Now that we have analyzed the optimistic effect of stock markets and financial institutions on economic growth, let's examine next the unhelpful milieu.

The shortfalls of the financial institutions role in the economic growth process

Until 2001, Enron Corporation, a firm oriented towards the trading in the energy market, appeared to the public successful. It occupies the one fourth of the energy-trading market and was valued at $77 billion in August 2000, making it the seventh largest corporation in the US during this year. However, in 2001, Enron collapsed and announced a $618 million loss along with disclosed accounting errors which had let the SEC to conduct a formal investigation of Enron's financials. It turned out that Enron was hiding large amounts of debt off of its balance sheet. In December 2011, the company declared its bankruptcy. The collapse of Enron raised the question of the confidence in the institutional pillars such as corporate disclosure, external audit and failure to notice by regulators and the SEC (Krishnaswany & Stuggins, 2003). This example shows that companies wanted to clean their balance sheets from risky projects so that to keep investors unaware of the risky portfolio they're holding. From this case, we point at the vital role of the financial information and how it is affecting negatively the confidence of investors in injecting their money in the unknown. If we break down the financial structure in the world, we find eight fundamental facts, out of which: -Marketable securities are not the primary source of financing for businesses in any country in the world, and stocks are not the most important source of financing. Let's illustrate this fact by the example of the vending machines stated earlier. This young graduate is unable to assess the real quality of the machine and therefore must pay an amount reflecting the average prices of the machines in the market. In contrast, the owner of a bad used vending machine will be delighted to sell it at the average price since it's sold above its real value. However, if the machine is good, the holder may not want to sell it at a price lower than its real value. This is a particular feature of the way the adverse selection problem interferes with the professional performance of the market and hence prohibits the pathway for the economic growth that shall exist through the transparency of the financial information under the wings of the regulators. This is exactly what describes the asymmetric information (a situation where one party's knowledge about conducting a certain transaction is insufficient; players in the same field don't hold the same amount of information) which envelops as well the moral hazard problem (situation where the borrower tends to invest the money in risky projects since if he gains, he will return the money and if he doesn't win, it won't be his money lost). If I carry LBP 37,500,000 and want to deposit this amount in a certain Lebanese bank, if this latter collapses, I lose everything, therefore I shall have full information of where the bank will invest my money which means that the bank have to be transparent to depositors so that savers have full confidence. The asymmetric information in this case is when the saver is unable to monitor if the bank is investing his money properly. When investors can't decide where to deposit and the bank isn't transparent, investors won't be able to fund their investments which will contribute to a downturn in the economic growth. From the investor's scale, he might want to subscribe to financial companies that will help him assess the value of any company he's intending to invest in. Mr. X knows that this investor has additional information, therefore he will react as a "free rider", and as a result he won't benefit from this information. We all know that the very first aim of any financial institution is to make loans, but can it help mitigate the asymmetric information? The answer is clearly YES, instead of lending the money to whomever, it shall lend borrowers with the most productive investment opportunities. The issue of free rider problem is very limited in financial institutions due to the reason that it issues private loans. This is why banks play an important role in sponsoring the activities of businesses more than securities markets do. Tools to help reduce adverse selection and moral hazard problems envelop the government regulation to increase the transparency and availability of information, collateral and net worth which will reduce the lender's loss in case the borrower defaulted and the monitoring and enforcement of restrictive covenants which will rule out each and every risky activity and will encourage desirable behaviors. In most developing countries such as Lebanon, the use of collateral is not always effective since bankruptcy procedures are too slow, creditors must first sue the defaulting debtor for payment which can take several years, then, the creditor has to go to court again to acquire title to the collateral. The process can take too long to the extent that by the time the creditor obtains the collateral, it may have been neglected and thus have little value. When the market is unable to use collateral effectively, the adverse selection problem will be worse since the requirements for additional information concerning the creditworthiness of the borrower is highly needed by the lender so to monitor the quality of the loan. In this case, there will be less outstanding productive investments which will induce a lower growth rate for the economy. Also, many developing countries enclose a weak regulatory system that makes it hard to provide adequate information to the market. For instance, accounting procedures implementations are somehow fragile making it hard for the lender to evaluate the borrower's balance sheet. Again, this inhibits the flow of money within financial systems to projects that may be productive and donor to the economic growth. Another issue raised as to defend the cause of the slow rate of economic growth in the MENA region is the issue of illiquid market. Liquidity refers to the degree, at which an asset is converted into cash. The financial crisis has worsened the liquidity complexities in these markets. In 2010, the exchange turnover ratio, which is the annual traded volume as a percentage of market capitalization, dropped throughout the region (Balzian et al., 2011). The ratios of Saudi Arabia, Kuwait and Dubai were around 70 to 75% below their 2008 level at respectively 57%, 37% and 35%. However, the NYSE's turnover ratio declined by just 29% during the same period standing at 98% in 2010. And as mentioned earlier, the MENA region suffers from a standardized clearing systems and proprietary systems. There was a hope that the crisis would encourage MENA governments to consolidate the regional capital markets and make them more open to worldwide investors, unfortunately, few measures have been taken into consideration and few were implemented, the issue that promised even more a very slow rate of growth. Referring to Blominvest Bank views on regional economic and financial developments for the second quarter of 2012, the overall economic activity in the Middle East, hardly hit by the eruption of the Arab Spring, reveals significantly quieter in 2012. The Egyptian revolution against the government was accompanied by plants shutdowns, simply economic downturn. Employees couldn't collect their salaries as banks stayed closed for a long period of time. While Egypt is characterized by a cash society, stores declined to sell on credit basis and ATMs were empty of cash, citizens were left with no liquid cash which pushed them to borrow money from friends so to buy the cheapest foods. The Egyptian stock market was closed as well because of this economic crisis. The Egyptian crisis slowed down the country's growth rate which affected the work of the Egyptian stock market. Rating agencies started to downgrade Egypt's foreign debt. Moody's cut Egypt's foreign currency bonds to Baa3 from Baa2 and foreign currency deposits to Ba3 from Ba2. Let's cover next the close example of Lebanon and the role of the Lebanese banks in the economic growth.

The case of Lebanon

High public debt and political instability hold back Lebanon's ratings. Credit ratings occupy a crucial role in determining the country's risk of default and as a result the corresponding yield on its debt issues. The grades are set as per many indicators such as the country's economic performance, Debt-to-GDP ratio and political security. Lebanon was firstly given a grade in 1997 by Moody's (B1) and by S&P (BB-) due to its risk of default and to the outstanding public debt. Lebanon's debt to GDP ratio had been estimated at 78% in December 1996. By 2000, Lebanon's debt accounted for $25.4 Billion amounting to 151% of total GDP. Lebanon's opportunity to break down the debt in 2002 so to build new confidence in its debt issues was accompanied by securing funds from the Paris II conference where the international community provided $2.4 Billion in direct financial support at maturity of 15 years and an interest of 5%. BDL and Commercial banks provided a total of $7.8Billion in long term loans, almost half of which with zero interest. This was shown in 2003 when huge capital inflows doubled BDL's foreign reserves to $10B. Furthermore, the rise in domestic consumption resulting from higher liquidity, and the result in tourist activity due to a relatively stable political environment stemmed an average economic growth rate of 3.77% between 2002 and 2005. Although Debt to GDP ratio was estimated at 176%, 2006 was a turnaround year for Lebanon's debt ratings despite the 1 month military clash that year. We can thus conclude from that the economic and political instability in Lebanon is the factor that's affecting stock markets, however, financial institutions and specifically commercial banks in Lebanon belong to a rigid industry under the umbrella of the Lebanese Central Bank.

Conclusion

In a nutshell, as a Lebanese citizen, I would like to note that Lebanese banks and especially the Central Bank is seeking a strategy that's obliging most of Lebanese people to become investors of the risk averse type. Commercial banks offer an average of 6.5% on all Lebanese deposits giving incentive to people to open savings deposits instead of investing this money in projects that may occupy a huge lack in Lebanon, such as infrastructure projects. On a daily basis, we see banks ads on TVs encouraging people to apply for all types of loans such as personal loans, wedding loans, and even plastic surgery loans, and we unfortunately lack some incentives on educating people for trading in the stock market that will enable them to maybe succeed more than depositing their money in the bank saving accounts. The taxi driver in the states holds a well diversified portfolio of stocks and bonds while here in Lebanon, we lack this lifestyle, this education that might really shift the whole economy into a higher level of educational growth, and thus contribute to an economic growth.

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